January 27, 2017 | Silver Stocks’ New Upleg

Adam Hamilton

Adam is the founder of Zeal LLC, a financial-market-research company specializing in contrarian speculation and investment. Zeal publishes weekly and monthly newsletters for contrarians looking for buying opportunities in deeply-undervalued sectors.

The silver miners’ stocks have surged higher in this young new year, putting the Trumphoria general-stock rally to shame. Following its fourth-quarter drubbing, this tiny contrarian sector is embarking on a major new upleg as traders return. Silver-stock uplegs tend to grow to massive proportions, and silver-mining fundamentals remain strong today. So odds are the silver stocks are going to power far higher in 2017.

Because silver stocks aren’t widely followed, most investors and speculators are unaware of this sector’s stellar upside potential. Silver mining is a challenging business both geologically and economically, so there aren’t many primary silver miners out there. And their stocks’ collective market capitalization is small, a rounding error compared to the broader stock markets. That doesn’t leave much room for funds to buy.

On top of that, silver itself is essentially a leveraged play on gold. The overwhelmingly-dominant driver of silver prices is gold-price action. Silver’s fortunes are inexorably slaved to gold’s own. So the great majority of contrarian capital flowing into precious-metals stocks naturally seeks out the far-larger gold miners. Silver stocks tend to fly under the radars of fund managers, creating exceptional opportunities.

For decades silver stocks even lacked a major dedicated index, making their performances relative to gold stocks difficult to track. Thankfully that started to change in April 2010 when Global X launched its SIL Silver Miners ETF. While SIL is tiny with just $361m in net assets this week, it is still nearly 5x bigger than its next-largest competitor. SIL has slowly become the definitive way to track silver stocks as a sector.

This ETF remains far from perfect, with well-known composition problems. SIL’s leading component is a major Mexican mining conglomerate commanding 1/8th of this ETF’s total weighting. While it is indeed the world’s largest silver miner, Industrias Penoles’ silver business only generated about a quarter of its total sales in Q3’16. Its stock doesn’t trade like a primary silver miner since silver is a minor side business for it.

Nevertheless SIL is the best silver-stock tracking vehicle we’ve got, reflecting how this sector as a whole is faring. SIL trends offer great insights into where silver stocks have been and more importantly where they are likely heading next. Here this leading silver-stock ETF’s price is superimposed over silver’s, which it naturally closely tracks. Silver levels drive silver-mining profits, and thus ultimately silver-stock prices.

A year ago in mid-January, SIL was battered to all-time lows in split-adjusted terms. Silver stocks were so deeply out of favor that Global X executed a 1-for-3 reverse split in SIL in mid-November 2015. No rationale was given, but I suspect SIL’s managers extrapolated the bearish trend and figured the silver stocks would keep spiraling lower indefinitely. They didn’t want SIL’s price to collapse into the single digits.

Since SIL was only created in April 2010, an all-time low doesn’t mean that much. At the same time, the leading gold-stock index was crushed to fundamentally-absurd13.5-year secular lows. The precious-metals miners have rarely been more out of favor than they were a year ago. But smart contrarians know the best time to buy low is when everyone else has abandoned a sector, when bearishness is extreme.

Indeed a new silver-stock bull was born right then in the depths of despair, and the silver stocks started surging dramatically. Silver-stock upside in bull-market uplegs is amazing. Silver-mining profits greatly leverage silver-price increases, dramatically improving this sector’s fundamentals. And with the entire silver-stock universe so small, relatively-minor capital inflows can fuel utterly-massive stock-price gains.

For the first half of last year, the silver miners’ stocks first rallied and then soared with silver. Of course they are strongly correlated with the metal they mine, since it almost solely determines their profitability. While silver peaked after gold in early August, strong momentum carried the miners higher for a couple more weeks. By that point SIL had skyrocketed an amazing 247.8% higher in just 6.9 months, fantastic gains!

Silver stocks’ upside leverage to silver in this young new bull’s initial upleg was huge. Silver just rallied 40.6% over that same span, so the silver stocks amplified its upside by an incredible 6.1x! If silver itself is heading higher, there’s no better way to play it than with the silver miners’ stocks. Any given silver-price rise translates into far-faster increases in silver-mining profits, leading stock prices to be bid sharply higher.

Despite silver stocks’ blistering early-2016 bull run, they weren’t unreasonably high by mid-August’s peak. That was merely SIL’s best level in 3.5 years on a split-adjusted basis, far from secular extremes. And the silver miners’ operating fundamentals certainly supported higher stock prices. In order to make better trading decisions in silver stocks, each quarter I dig into the latest operating results from the SIL components.

As of Q2’16, the quarter before silver stocks peaked, the top 17 SIL stocks were mining silver at average all-in sustaining costs of just $10.05 per ounce. That was this industry’s total cost of producing including everything necessary to maintain and replenish operations at current silver-production levels. As silver prices averaged $16.79 in Q2, the elite silver miners of SIL were earning very impressive 40% profit margins.

There was no fundamental reason for a silver-stock correction, although there were plenty of technical and sentimental ones. Silver stocks had soared very far very fast, and investors and speculators were getting quite bullish and greedy. Corrections are perfectly normal and healthy in ongoing bull markets to bleed off excessive greed and rebalance sentiment. I warned in early July that a correction was likely.

But silver-mining fundamentals were still rapidly improving while the red-hot silver stocks sold off in the subsequent months. While silver miners will soon report on Q4’16, their latest results are still Q3’16’s. The top 17 SIL silver miners’ average all-in sustaining costs merely edged up 0.8% quarter-on-quarter to $10.13 per ounce. Yet the average silver price powered 16.4% higher QoQ to $19.55 in Q3, ballooning profits.

The elite silver miners’ profits really leveraged silver’s gains, surging 39.8% higher to $9.42 per ounce! This industry’s profit margin at 48% was enormous, and certainly justified further silver-stock gains. But a normal correction went off the rails in Q4 due to several anomalous events. Silver’s primary driver gold suffered no fewer than three major anomalous selloffs, and each sucked in silver and therefore silver stocks.

In early October silver plunged after gold futures suffered cascading stop-loss selling as $1300 support started failing. Naturally that extreme selling quickly burned itself out, so silver and SIL started grinding higher again into early November. Then Trump’s surprise election win stoked the incredible Trumphoria stock-market rally, leading to heavy gold selling. Gold is the anti-stock trade, tending to move counter to stocks.

Again silver quickly started to rebound from that second anomaly, so silver-stock levels stabilized. But a third body blow soon arrived in the form of more gold-futures selling right after the Fed hiked rates for the second time in 10.5 years in mid-December. So silver again followed gold lower. Silver traders have always looked to gold for their trading cues, so nothing else is more important for prevailing silver prices.

So by late December, what started out as a normal and healthy silver-stock correction had mushroomed into a gross monstrosity. SIL had plunged 42.5% in just 4.2 months, far beyond the normal range of bull-market corrections. But impressively that was on a huge 20.1% silver plunge. So SIL leveraged silver’s extreme downside in Q4 by just 2.1x, which was far less than its enormous 6.1x upside leverage in early 2016!

Silver stocks’ resiliency in an extreme silver correction illustrates their asymmetric upside potential. This beaten-down sector has much-higher odds of soaring higher than collapsing lower. Before this past year’s young new silver bull, silver stocks were battered relentlessly in the dark years from 2013 to 2015. That spawned such epic bearishness that everyone susceptible to being scared into selling low is long since out.

So even though silver stocks as represented by SIL were battered back to April levels in late December, an 8.2-month low, this sector looked wildly bullish. That setup a month ago felt much like last January’s brutal secular lows. Everyone was bearish, totally convinced silver stocks were doomed to keep falling. So near those lows we aggressively bought and recommended trades in great silver stocks in our newsletters.

That contrarian call has since proven wise, just like a year ago. As of earlier this week, SIL has already powered 24.4% higher out of those excessive lows! Year-to-date it has already soared 19.5% at best, trouncing the Trumphoria gains in the major stock indexes. Silver stocks’ surge over the past month has all the hallmarks of a major new upleg just starting. It has the potential to ultimately eclipse early 2016’s monster.

While the silver miners’ Q4 results haven’t been released yet, there’s no way they are going to justify SIL’s terrible 27.8% plunge last quarter. Remember the top 17 SIL-component silver miners averaged all-in sustaining costs of $10.05 and $10.13 in Q2 and Q3. So it’s reasonable to assume they will stay around $10 in Q4. They’ll likely actually fall, as silver miners tend to pull in the horns when silver weakens.

For all the sound and fury of Q4, the average silver price was still $17.12. While down by about 1/8th from Q3’s average, this still likely leaves the elite silver miners with excellent profit margins around $7 per ounce. That is right in line with Q2’s which ran $6.74. Silver stocks soared that quarter on those kinds of operating margins, blasting 63% higher. There’s no way late-December’s silver-stock low was righteous!

If a major new silver upleg is indeed underway, silver stocks are going to enjoy another fantastic year in 2017. Despite their miserable anomalous Q4 selloff, SIL still soared 73.5% higher in 2016! I suspect the silver stocks will see even-bigger gains this year. As of this week, silver has only climbed 9.1% off its own late-December low in the wake of that Fed rate hike. That’s nothing for an upleg in a silver bull.

Remember SIL rocketed 248% higher in largely the first half of 2016 on a 41% silver upleg. Despite silver’s gains it still remains really undervalued relative to its primary driver gold. So silver is very likely to mean revert much higher in 2017, which will again drive wildly-disproportional gains in silver-stock prices as their profits leverage silver’s advance. This is easiest to understand with the Silver/Gold Ratio.

This SGR simply divides the daily silver close by the daily gold close. Technically that results in little decimals that are hard to parse mentally, so I prefer using a scale-inverted gold/silver ratio which is the same thing. It yields more meaningful whole numbers like 71, which is where the SGR stands today. This is way too low relative to gold based on historical precedent, an unsustainable deviation to be unwound.

This week it took almost 71 ounces of silver to equal the value of one ounce of gold. That’s really high historically, meaning silver prices are really low relative to gold. The average SGR before 2008’s stock panic was 54.9, which is why 55 has long been assumed to be “fair value” for silver relative to gold. That stock panic really whacked highly-speculative silver disproportionately hard, wildly distorting this relationship.

But as in all market extremes, those panic-level silver prices were short-lived. Silver soon mean reverted dramatically higher, rallying far faster than gold which is necessary to drive the SGR higher. Like usual after extremes, that mean reversion didn’t stop at the 55 average. Instead it overshot proportionally to the opposite extreme, briefly pushing the SGR as low as 31.7! Silver’s price had to rocket over $48 to achieve that.

During the normal post-panic years from 2009 to 2012 before the Fed’s open-ended QE3 levitated stock markets and crushed precious metals from 2013 to 2015, the SGR averaged 56.9. So there’s plenty of pre-panic and post-panic precedent for an SGR near 55 being normal. Silver is undervalued relative to gold when the SGR is higher, and overvalued relative to gold when it’s lower. Silver is still too cheap today.

Early last year soon after gold, silver, and their miners’ stocks were battered to major secular lows, the SGR was briefly pounded to a panic-level extreme of 83.2. It took an astounding 83 ounces of silver to equal the value of a single ounce of gold! Back then I used this same SGR chart to point out that silver was a coiled spring, ready to explode higher. And indeed that soon came to pass as the SGR started to mean revert.

By mid-July the SGR had soared as high as 65.9, which was still well below the 55 long-term average. But that trio of gold-driven silver plunges in Q4 bashed the SGR back down to 73.2 in late November. It has merely rebounded to 70.8 as of this week. That means silver still has lots of mean-reversion rallying left to do even with today’s prevailing gold prices. Let’s assume that post-panic average 57 is silver’s fair value.

At $1200 gold, a 57 SGR implies a silver price near $21.00. That’s another 24% higher from this week’s prevailing levels. There’s no doubt that if silver rallies another quarter or so from here back to those prices, which are above early-August 2016’s silver peak, the silver stocks are going to soar again. At similar 6x upside leverage to early last year, that alone could drive another 150%ish surge in silver-stock prices!

But that simple SGR mean reversion isn’t even the bullish part yet. Gold itself is also likely to continue mean reverting much higher, and the SGR should overshoot proportionally to the opposite side after last year’s panic-level extremes. Gold is now set up for massive new buying from two fronts, American stock investors buying GLD shares and American speculators buying gold futures. That will catapult gold far higher.

Between 2005 and 2011, gold’s average annual gain as capital flowed in was 20.3% without a single down year. So let’s conservatively assume gold enjoys an average bull-market year in 2017 with a 20% gain, putting it near $1380 by year-end. Plug an average 57 SGR into that, and it yields a silver-price target near $24.25. That’s another 43% higher from this week’s levels, a major upleg exceeding early 2016’s.

But assuming the SGR will merely stop at average after a panic-level extreme is way too conservative, as mean reversions out of extremes tend to overshoot proportionally to the opposite extreme. For years before 2013’s Fed-driven gold plunge, the SGR’s trading range had meandered between 60 and 45. So a modest SGR overshoot to 45 is almost certain. At $1380 gold, that would push silver back over $30.50.

That’s another 81% higher from this week’s levels on conservative assumptions. So it’s certainly easy to argue the case that the silver miners’ stocks still have upside potential in the hundreds of percent! I’ve been trading silver and silver stocks for decades, and I strongly suspect that the big gains we saw early last year were just a small foretaste of the great feast to come. Smart contrarians are aggressively buying!

So while silver’s own mean reversion relative to gold can be played with that leading SLV iShares Silver Trust silver ETF which tracks the metal itself, the gains in the silver miners will dwarf those in silver due to their great inherent profits leverage to the metal they mine. SIL is the leading ETF for silver-stock exposure, but the gains in elite individual silver stocks with superior fundamentals will really outshine SIL’s.

At Zeal we aggressively bought and recommended great gold stocks and silver stocks to our newsletter subscribers back in December when everyone remained hyper-bearish. Our unrealized gains on these young trades are already running as high as +48% this week! If you too want to thrive in these markets, it is essential to stay informed all the time. Wealth is multiplied by first buying low when few others will.

We’ve been in the contrarian-research business helping investors and speculators thrive for over 17 years now. Since 2001 we’ve recommended and realized 906 stock trades in real-time to our newsletter subscribers. Their average annualized realized gains including all losers are now running way up at +22.0%! You can put our expertise to work for you through our popular weekly and monthly newsletters. They draw on our vast experience, knowledge, wisdom, and ongoing research to explain what’s going on in the markets, why, and how to trade them with specific stocks. Subscribe today for just $10 per issue!

The bottom line is silver stocks are embarking on a major new bull-market upleg. After getting crushed in the fourth quarter on a series of anomalous gold selloffs, this sector has rebounded dramatically over the past month. The silver miners’ great inherent profits leverage to the metal they mine is kicking in again as silver mean reverts higher. Investors and speculators alike are returning to chase this earnings growth.

And silver stocks’ market-leading gains are likely just the vanguard of far-larger ones coming. As a small sector, it doesn’t take much capital flowing in to propel silver stocks dramatically higher. Thus their bull-market uplegs tend to grow huge as they mature. And with silver still way undervalued relative to even prevailing gold prices let alone where gold is heading, it has a lot of profit-generating mean reverting left to do.

Adam Hamilton, CPA

January 27, 2017

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